What 2014 won't change

Indian Express, 26th November 2013

There are no more stroke-of-the-pen economic reforms, no shortcuts

That a change in government in 2014 will bring back the higher rate of GDP growth that we experienced a few years ago is an increasingly popular view. While there may be an upturn in exports, due to the recent depreciation of the rupee and the pick up in the US economy, and some improvement in domestic investment, sustaining a high rate of growth requires longer-term solutions. These solutions are not difficult, but could take some time to put in place. In the meanwhile, GDP growth may still pick up a little in 2014-15. There are two components of the slowdown: the trend growth rate and business cycle conditions. While the business cycle conditions may improve in the coming months, the trend growth rate remains a problem.

Has India's trend growth rate slowed down? Long-term trend growth rates of economies, such as a 30-year average growth rate, have been one of the least understood and most unpredictable variables in the field of economics. The accumulation of capital, human capital, institutions, rule of law, infrastructure, political systems, and productivity growth change in ways little understood by economists even today. Their impact on long-term growth remains even less understood.

Scandals in the allocation of spectrum, coal blocks and land, and projects that have been stalled due to environmental clearances have certainly worsened the medium-term growth rate. But if these factors affect the long-term trend it implies that India does not have the institutions it needs to solve these problems. Despite all the gloom and doom, this is a view that is hard to find. One of the characteristics of Indian democracy is that even though it takes time to build the state's capacity, which is one of the biggest challenges that needs to be surmounted in order to deal with the issues of the day, it is not impossible to do so.

Recent problems have highlighted the limitations of the Indian state's capacity. For example, stalled projects are a major reason for the slowdown in investment today, which is in turn responsible for slower growth. But the growth in investment can only become smooth if there is a serious change in the way in which firms interact with the government. The state's capacity needs to be enhanced and it needs to move away from the old systems that were designed to function under the licence-permit raj.

For example, had proper legal, regulatory and policy frameworks been in place for the protection of the environment, so many projects would not have been stalled. The fast pace of GDP growth meant that there were suddenly several projects where the trade-offs between growth and environmental protection became pressing. Due to the lack of set standards and regulatory mechanisms, each project had to, on a case-by-case basis, be cleared by local, state and Central bureaucrats, many of whom did not understand the basis on which a clearance was to either be given or withheld. The number of projects stuck in the pipeline became greater. It is the lack of a policy framework that scares bureaucrats from clearing projects today.

With the right institutions, there would have been no need for a Central body to clear stalled projects. Many clearances have been given by the Cabinet Committee on Investment. Others will also be given. But does this mean that the problem is solved? That in the future, projects will not get stuck? Unlikely. Without a change in the legal and regulatory framework, India cannot thunder ahead at a 10 per cent growth rate for 30 years like China has done. The demands for transparent and non-discretionary systems for the allocation of resources like land, spectrum, mines and contracts, for well-designed regulatory frameworks, and for clearly defined policies are likely to increase in the coming years. But building the state's capacity is unlikely to be a quick process. Indeed, if it were, then it is less likely to provide us with frameworks that can pass the test of time.

What is this process of change and why might it take so long? The process of financial sector reform is an illustrative example. First, we faced a problem. Slowly evidence started to build up that the problem was not an isolated incident. Then the media, think tanks and academics analysed the data and identified deeper problems. This was followed by committee reports, which involved broad consultations and offered recommendations. In the case of the financial sector, committees such as the Raghuram Rajan committee, the Percy Mistry committee and the U.K. Sinha committee helped form the consensus on the reforms needed. Many changes were made and often legal hurdles came in the way. The government then set up the Financial Sector Legislative Reforms Commission (FSLRC) to review the existing laws. The process of writing a draft law involved studying all the existing laws relating to finance. A full-time 30-person research team of economists and lawyers at the NIPFP supported the commission. After consulting more than 170 people, creating various working groups that analysed specific problems and many long meetings of the commission, a broad consensus was formed on most issues.

The FSLRC submitted its report after the designated two years. The process of legal change will take at least another two to three years. The setting up of the new regulators and the framing of the relevant rules under the new laws are likely to take even longer. Hundreds of regulators, lawyers and judges will need to familiarise themselves with the new legal framework. Companies will need to reinvent themselves.

In the case of financial reform, one can argue that there is at least some consensus. In other areas, the problems are more recent and there is no clarity on what needs to be done. The process of change will therefore take longer. As it should.

India has seen the slow and gradual build-up of the state's capacity. There are no more stroke-of-the-pen reforms left, there are no shortcuts. Hopefully, we will be lifted out of the present downturn thanks to an upturn in the global economy. But we will need to build frameworks to create a healthy interaction between firms and the state. Today's system was designed for a command and control economy. That will hopefully change over the next few years and keep India's trend growth rate high.

Inflation-targetting is critical

Financial Express, 25th November 2013

After some months of a falling WPI-based inflation, the numbers have picked up again. Food inflation has risen, but the full pass-through of a depreciated exchange rate is yet to be seen and may push up non-food WPI inflation as well in the coming months. The Indian inflation story can, at best, be summarised as one where the monetary policy stance has failed to anchor inflation expectations in the economy. Among the main problems have been Reserve Bank of India's multiplicity of goals, instruments, lack of transparency in monetary policy strategy, and poor communication efforts. Looking forward, an effective strategy to combat inflation depends on a public announcement of the medium-term numerical inflation target, a clearly articulated commitment to price stability as the sole target of monetary policy, a well-espoused instrument of monetary policy, and an accountability (to the Indian public) mechanism.

One way to move ahead is to keep the framework informal, where RBI chooses to do the above depending on the willingness and the political clout of its Governor, which Raghuram Rajan is, no doubt, well-placed to do. The other is to enact it as law. Most inflation targeting countries include the objectives of monetary policy in the law. This helps to build credibility of the framework and create channels of accountability. Despite similar monetary and fiscal environments, evidence suggests that those who have clear inflation-targeting regimes are better able to achieve low and stable inflation than those who do not have an explicit inflation-targeting framework in place.

February 2006 onwards, inflation breached the upper bound of 5%. It has never come back to the below-5% levels. If our informal goal was to get inflation between 4% and 5%, we have failed to do this as measured by average inflation from 1999 onwards.

Undoing the benign inflationary environment till December 2007, the global commodity prices environment drove prices upwards across all emerging market economies, including India. However, India has been singled out for the speed with which present inflation feeds into its inflation expectations. In other words, it is likely that economic activity will incorporate present inflation as one that will persist into the future, thereby delivering high inflation in the future as well.

The question of anchoring inflationary expectations depends on two critical factors: the magnitude and timeliness of response to prevailing inflationary conditions. Has RBI done enough to anchor inflation expectations? To explain this, Riccardo Christadoro and Giovanni Veronese of the Banca d'Italia compared the present short-term interest rate with what would be obtained by the Taylor Rule since January 2008. Except for the third and fourth quarter of FY09, where the interest rate set by RBI was much lower than prescribed by the Taylor Rule, on all occasions, interest rate changes by RBI were at least two percentage points lower than what one would expect to combat inflation. On the one hand, interest rates were not high enough in India during inflationary conditions and on the other, lower than required during the two quarters of extreme global conditions.

It is important to note that this analysis does not exclude growth concerns as the Taylor Rule responds to output gap as well. Some studies have also suggested that the output gap dominates inflation in determining movements in policy rates in India. It may now well be the occasion to rebalance this prevailing bias in the monetary policy rule of RBI.

What can be done? Whether inflation is initiated by higher food prices or otherwise, monetary policy has a role to play if general inflation fears get embedded in expectations. The world adopts several approaches to combat this problem. Several peer economies have adopted a clearly articulated monetary policy strategy to combat inflation. Brazil, for example, has had a long history with inflation and inflationary expectations. Brazil and more than half of the emerging market economies, at various points in time, have adopted similar strategies to combat this problem. Detailed studies generally suggest that when otherwise similar emerging market economies are compared over same time periods, key macroeconomic variables such as inflation and output performed better in countries that adopted this framework compared with those that did not. Taking a leaf out of its peer central banks across the world, RBI could pursue price-stability through a multi-pronged strategy:

*Public announcement of a medium-term target: The first step towards clarifying the intent of monetary policy is the public announcement of a medium-term inflation target. This acts both as an information to the market and as one that holds the central bank accountable. There has been some progress on this. Rajan has recently announced a 5%-WPI target. At some point he will need to move to a CPI target, but for the time being, this is better than the RBI policy before his announcement.

*Defined instrument of monetary policy: The second step in the process of anchoring inflation expectations is laying emphasis on a short-term interest rate as the tool. RBI is expected to move to the repo rate as the tool. But today, this is not solidly in place. Hopefully, the Urjit Patel committee will be able to clarify this.

*Articulated commitment to price stability: A well-articulated commitment to price stability will not have the RBI Governor opposing the idea of price-stability being central to the functioning of RBI. This has been witnessed repeatedly since 2008, and is now being reversed by Governor Rajan. RBI needs a shift in emphasis away from the exchange rate to price-stability in all its communications. The market will need to understand that what drives RBI policy is not keeping the rupee stable in the short run, but ensuring low inflation (which will keep the rupee stable in the long run).

*Accountability mechanism: This requires a clear monetary policy law where the central bank is given the responsibility of achieving price stability while not being burdened with conflicting objectives. This is the way forward.

Trial by taper

Indian Express, 13th November 2013

We need to prepare for the end of QE. Keeping inflation low is our best bet.

US job data for October showed higher employment growth than was earlier expected. This good news sets the stage for the US Fed to reduce quantitative easing. However, the uncertainty over the US debt deal means that this may not happen until March 2014. Still, sooner or later, the tapering will start and emerging economies like India have to be prepared for it. The tapering is likely to take a while to complete - it may be a few years before the Fed gets back to a normal monetary policy. For India, this means that the preparation to deal with it must be in the form of a framework of sustainable policies, rather than temporary measures. Low inflation, fiscal consolidation and addressing the structural problems of growth offer sustainable solutions. While quantitative measures and restrictions to control the current account deficit only offer temporary quick fixes.

The market's reaction to the May 22 "tapering speech" by the Fed chairman, Ben Bernanke, was more extreme than anyone had expected. One, long-term interest rates in the US went up immediately and two, capital flowed out of emerging economies (EMs), resulting in the sharp depreciation of their currencies. This was especially the case among those economies that were more vulnerable due to large current account deficits. Many EMs resisted the depreciation, either with an interest rate defence or, as in India's case, with a series of capital controls and other restrictions on foreign exchange markets.

These knee-jerk reactions were often ineffective and in some cases made the depreciation even sharper. Exchange rates overshot and sentiments worsened. It is inevitable that the US Fed will, sooner or later, have to reduce the purchase of government and agency bonds, which it is currently undertaking. Currently, the Fed is purchasing bonds worth $ 85 billion per month. Any signal or action from the Fed - including about whether its bond purchase programme will be reduced gradually or sharply - is bound to affect global financial markets.

There is a strong possibility that the inevitable tapering has already been factored in by financial markets. There is no doubt that the Fed's communication will be far more careful now, so as not to generate expectations that it's going to suddenly end all purchases. US long-term rates have already risen and may remain stable. EM currencies have also depreciated in comparison to their mid-May exchange rates and may not depreciate any further. However, there is, say, a 20 per cent probability that when the tapering actually begins, financial markets will once again see high volatility, US long-term rates will increase and EM currencies will depreciate further.

This time, EMs must not be caught unawares. The question is: how can they prepare for this event? Countries with high inflation, such as India, were the most affected this summer. They also tended to have high current account deficits, as rising inflation with stable nominal exchange rates had rendered their exports uncompetitive, while imports became more attractive. The real appreciation in the exchange rates needed correction, which happened rapidly when there was a sudden reduction in the inflow and increase in the outflow of capital. The depreciation of the nominal exchange rate was, therefore, an adjustment that was on the cards to the extent that it would help correct the current account deficit.

High current account deficits and inflation are, in many cases, the consequences of the expansionary fiscal and monetary policies that were followed by many EMs in the years after the 2008 crisis. In 2009 and 2010, many EMs, including India, in an effort to offset the demand contraction arising from the decline in exports and private investment, implemented expansionary fiscal policies. For example, India cut tax rates and raised spending. This fiscal expansion was accompanied by a loose monetary policy - interest rates stayed too low for too long. Though the RBI raised nominal interest rates, the 13 hikes of 25 basis points each were too little to push up real interest rates, as inflation was rising faster than the nominal rate. This resulted in a further rise in inflation.

In order to prepare for the beginning of the end of quantitative easing, inflation must be brought under control. Global inflation is low. If inflation in India continues to be higher than our partner and competitor countries, as it has been in the years since 2008, there is a high probability that Indian exports will become uncompetitive, imports will become more attractive and the trade deficit will rise. When the tapering begins, the rupee could depreciate suddenly, create balance sheet mismatches for firms that have borrowed abroad, push up oil prices or subsidies and raise inflationary expectations. Countries that have kept inflation under control have less to worry about, due to a smaller impact on their exchange rate and a less adverse effect of a depreciation, were it to occur, on inflationary expectations.

Reducing inflation, in what might be a short window before the tapering starts, is not easy. Inflation has been high and persistent for nearly four years now, and inflationary expectations are heavily entrenched. The RBI governor, Raghuram Rajan, is moving in the right direction by focusing on inflation. This is the sustainable path to reducing the current account deficit and India's vulnerability to a sudden stop in capital inflows. Consumer price inflation in India has been above the RBI's target levels of 5 per cent since 2006. It has been rising ever since, and not enough tightening was done in 2008-09 to pull it back on track. Bringing inflation down will be a slow and painful process. It will be helped by the slowdown in demand because investment has slowed down sharply. The need to raise rates may not be as pressing as it otherwise might have been. However, if savings are to be raised, gold imports to be genuinely reduced (rather than simply re-routed through smuggling) and investment activity revived, low and stable inflation is a necessary condition.

Respite as opportunity

Indian Express, 24th October 2013

Before the next wave of volatility, emerging markets must set their house in order.

The recent slowdown in GDP growth and some of its causes are not unique to India. While a lot of our problems appear homegrown, it is interesting to note that several emerging economies are facing similar downturns. This sudden deceleration of growth in emerging markets (EMs) poses challenges for the world economy. EMs had contributed significantly to global growth and a slowdown in these economies could result in a downturn for the world economy. Global growth forecasts have been cut primarily due to the sluggish growth in emerging economies.

This slowdown was the focus of many a debate at the annual meetings of the IMF and the World Bank earlier this month. Almost all EMs are now showing a decline in GDP growth. Further, most forecasts for EM growth have been cut. The discussion suggested that emerging economies will face three major challenges in the coming months: high volatility of capital flows, a cyclical downturn and structural problems.

The high volatility of capital flows in recent times stems from the anticipation of decisions that are yet to be taken by the US Fed. Everyone understands that the Fed must cut back on its asset purchases. Indeed, it is argued that they are no longer necessary, as the balance sheet of the Fed is large enough to support much greater credit growth if there was enough demand for it. The money multiplier has fallen sharply. While there is an increase in reserve money growth, the corresponding growth in money supply, which happens only when there is demand for credit and lending by banks, is much lower. However, the asset purchase programme of the Fed has also become a signalling device. As long as the Fed is buying assets, people believe that long-term interest rates in the US will remain low.

Ben Bernanke's carefully drafted May 22 communication, that the Fed must now start devising a strategy to reduce its asset purchases, was read by jittery financial markets as an announcement of the programme's withdrawal. The nervousness of the markets, and the perception that the Fed's purchases must be reduced and eventually stopped has created a tense situation. Every tiny bit of information about the US economy has the potential to induce the entry or exit of waves of capital in the US. The impact on EMs has been far greater and more sudden than what was initially expected. Not only is there no prior example of such unconventional monetary policy, the inflows and outflows of capital from EMs are not symmetric. When the Fed purchases started, the inflow into EMs was slower and less dramatic than the outflow has been now.

Some observers believe that the May-July drama was only a trailer of what is to come when the Fed actually starts tapering its bond purchases. Market participants and investors seem to be bracing themselves for higher volatility. Others believe that the markets have already factored in the effect of a US tapering - the corrections that were to be made in investor portfolios and EM currencies have already been made. Policy-makers, especially among emerging economies, prefer to think that the worst, in terms of market volatility, is over. This is understandable, as there is a limited menu of possible responses.

The most common opinion appears to be that before the next wave of volatility hits financial markets, that is, before the US Fed starts talking about tapering again, emerging economies with weak macroeconomic fundamentals should set their house in order. As of now, EMs have got some respite. This is mainly due to two reasons. First, US unemployment numbers showed a reduction in labour participation, suggesting that the labour market is not healthy, so a reduction in the unemployment rate cannot be taken literally. Second, the fiscal contraction in the US has slowed down the expected pace of recovery.

Setting one's house in order is not easy, especially since growth is expected to be slower. For example, even though slower growth is forecast, both for cyclical and structural reasons, the IMF has suggested that EMs undertake fiscal consolidation. India, for example, overdid its fiscal stimulus in 2009 and 2010 and a correction for this would entail fiscal contraction. This could, however, impact emerging economies' growth rates adversely. On the monetary policy front, while the IMF did not say that emerging economies should maintain a tight monetary stance in response to higher US interest rates, it did recommend that countries with high inflationary expectations put in place a sound framework for monetary policy. However, in many countries, such as India, this would mean a tightening of monetary policy. A framework may not be credible or capable of pulling down inflationary expectations unless such a tightening were undertaken. But tighter monetary policy could mean a further contraction in output.

In the aftermath of the recent volatility, two distinct sets of countries seem to have emerged. First, those that have sound macroeconomic fundamentals - small fiscal and current account deficits, and low inflation. Second, those that had witnessed fiscal expansions and inflation that was higher than world inflation in recent years. Countries like Mexico and Chile appear to be well prepared for the tapering, with sound fiscal and monetary policies in place, but they have slowed down for structural reasons. They need to undertake structural reforms. Other EMs have to counter the impact of tighter fiscal and monetary policies. Structural reforms like building infrastructure, creating greater labour flexibility and a good business environment can increase growth. But such long-term reforms are a political process. In democratic countries like India, Turkey and Brazil, they require building political consensus and are not quick and easy.

The only instrument that might help is currency flexibility. An assessment of currency mismatches suggests that emerging economies are better placed and more resilient today than in the past. Countries that allow currency depreciation might be in a better position to take advantage of the pick-up in the US economy and world trade than those that do not. For emerging economies like India, the coming months might witness slower growth, higher volatility, contractionary fiscal policy and monetary tightening.

Rajan vs RBI

Financial Express, 22nd October 2013

The Reserve Bank of India (RBI) is said to be gearing up to initiate an interest rate futures market yet again. Will the product be a success, or will it fail like the previous attempts? The most important factor that favours success this time is Governor Raghuram Rajan. The most important factor that works against it is the old RBI mindset that fundamentally mistrusts markets.

Why might this time be different? In contrast to the earlier approach of micromanagement, Rajan's view as indicated in the Raghuram Rajan report indicates that exchanges should have the freedom to design products. It says:

Exchanges should have the freedom to structure products according to market needs. The issue of removal of 'segments' of exchanges becomes particularly important with interest rate derivatives.

This time we may thus expect that RBI will change its policy of control and command and dictating the product it wants traded regardless of the market for it.

Second, in the past, a key method that has been used to prevent the emergence of a market has been to interfere with rules about participation. Certain kinds of financial firms are cut off from accessing the bond depository (which is run by RBI), or the CCIL, or currency futures trading, etc. This is a contrast with the strategy of the equity market, which is open to everyone. If a market has to get liquidity it needs all kinds of participants. For example, if there is demand from foreigners who are buying government bonds to hedge, then they will bring liquidity to the currency and interest rate futures markets and should be allowed to participate.

What is different this time? Again, the difference may lie in Rajan's approach. The Rajan report says:

The architecture of trading with SEBI-regulated exchanges is conducive to free entry for financial firms and free entry for participants. As an example, currency and interest rate derivatives could become immediately accessible to all financial firms and all market participants (for example, FIIs) by bringing them into the existing policy framework of SEBI-regulated exchanges.

Third, in the past, the market design of the product has prevented 'cash settlement' of interest rate derivatives.

In contrast, the Rajan report says:

Exchange-traded interest rate derivatives using both cash settlement and physical settlement should be permitted. These can trade alongside equity derivatives on NSE and BSE.

Fourth, in the past, it was claimed that the existence of interest rate derivatives interfered with the conduct of monetary policy.

The Rajan report says:

Monetary policy involves changes in the short-term interest rate by the central bank; the Bond-Currency-Derivatives Nexus would enable the 'monetary policy transmission' through which changes in the short-term policy rate reach out and influence the economy through the market process of changes in all other interest rates for government bonds and corporate bonds.

It may, therefore, be expected that this time the development of the interest rate derivatives market will be seen as something RBI will see as a help to improving monetary policy transmission, rather than something that weakens it.

Fifth, in the past, it was believed that short-selling is bad and speculation and arbitrage is evil. A liquid interest rate futures market, and an arbitrage-free yield curve, requires the ability to borrow government bonds and sell these borrowed bonds. These were discouraged. Hedging was permitted, but you could not buy derivatives unless you held the underlyings. So only banks holding government bonds could buy interest rate derivatives. This way, the market did not get diverse positions or liquidity.

The Rajan report says:

In a well functioning financial system, all these prices-exchange rates, interest rates for government bonds and interest rates for corporate bonds-are tightly linked through arbitrage. The key policy goal in this area lies in fully linking the markets, and for these markets to (in turn) be linked to other financial markets such as the equity market. When India achieves a well functioning BCD Nexus, this would have a number of implications. It would enable funding the fiscal deficit at a lower cost and with reduced distortions.

There are, of course, prudential concerns about this and they are addressed by the mechanism that is being used for borrowed shares. In India, the clearing corporation becomes the legal counterparty when shares are borrowed. This eliminates counterparty credit risk. This identical mechanism can be easily used with bonds.

Sixth, in the past, policymakers have muzzled the market when they do not like what the market is saying. Of essence for the future is a more mature perspective, where the market is viewed as a aggregator of the views of the economy. When the message from the market is bad, shooting the messenger only makes it worse.

Indeed, the bond market and the currency market are powerful sources of accountability for the government. When policymakers make mistakes, which will induce bad outcomes in the future, the market makes a net present value about future outcomes and reports it as the price right now. This generates a feedback loop which gives short-sighted policymakers immediate responses when mistakes are made that will lead to damage in the long run. If we want economic policy in India to fare better, it is important to unmuzzle the Bond-Currency-Derivatives Nexus.

The Rajan report says the following about the BCD nexus:

It would produce sound information about interest rates at various maturities and credit qualitie...

In summary, we may expect the outcome on RBI's initiative on interest rate futures to be different if the Governor's view prevails over the old RBI mindset in which the command and control instinct dominated. If, instead, in the old style, ways are found to restrict, stifle, manipulate, control and micro-manage the interest rate futures market are found by the staff used to dealing in the old way, this could become another failed attempt.

Forming new bonds

Indian Express, 16th October 2013

India must lift restrictions on foreign investment in rupee denominated debt

The global financial crisis has heightened fears about integration with global financial markets. For a country like India, which should inexorably open up further to global markets, an important task of policymaking is to identify the path of this integration. It lies neither in shutting out foreign capital, nor in recklessly opening up to dollar denominated debt, which has landed many a country in trouble.

A recent Sebi study on foreign investment in government bonds has recommended the removal of quantitative restrictions on foreign holdings of rupee denominated debt and moving towards a framework similar to the one for foreign portfolio investment in equity. In this study, my co-authors and I find that India's capital controls continue to be guided by concerns about debt and its maturity, rather than its currency denomination. For example, India has placed many restrictions on foreign investment in rupee denominated bonds, even though this is one of the safest areas to open up. This is because the currency risk is borne by the foreigner and there is a foreign appetite for rupee denominated debt. Currently, the restrictions include caps on the total amount of rupee denominated bonds that a foreigner is permitted to hold as well as limits that vary by investor class, maturity and issuer. These have been implemented through a complicated mechanism for allocation and reinvestment. The restrictions fail to meet the objectives of economic policy today and must be removed.

In 1991, India embarked on its integration with the world economy through trade and capital account liberalisation. A key idea behind the early decontrol measures was that debt inflows were dangerous and, therefore, strong restrictions need to be placed on them. Restrictions were imposed to shift the composition of capital entering India towards non-debt-creating inflows and to regulate external commercial borrowings (ECBs), especially short-term debt. As a consequence, while the framework for FDI and portfolio flows is relatively liberal, India has a number of restrictions on debt flows.

Over the past decade, the global thinking on debt flows has changed. The macroeconomic and financial instability in emerging markets following the crises of the late 1990s has led to increased efforts in these countries to develop local currency denominated bond markets as an alternative source of debt financing for the public and corporate sectors.

In the 2000s, emerging economies' domestic bond markets have grown substantially. The outstanding stock of domestic bonds now exceeds $6 trillion, compared to only $1 trillion in the mid-1990s. Along with this, foreign participation has also increased substantially over the last decade. In contrast, the Indian policy framework on debt flows, characterised by quantitative restrictions on foreign participation, has resulted in limited foreign investment. There is a strong case for opening up the local currency government and corporate debt market to foreign investors.

The present arrangement governing foreign borrowing comprises two parts. First, dollar denominated debt: India raises capital through foreign currency denominated debt via government borrowing (both bilateral and multilateral), ECBs by firms (including foreign currency convertible bonds and foreign currency exchangeable bonds) and fully repatriable NRI deposits. Second, rupee denominated debt: Foreign investment in rupee denominated debt takes the form of foreign investors buying bonds in the Indian debt market, which is denominated in rupees. This is subject to an array of quantitative restrictions. There are different limits for foreign investment in government and corporate bonds. This arrangement is further complicated by sub-limits across assets and investor classes.

The share of outstanding government bonds that are owned by foreign investors has risen through the years. As of March 2013, it stands at 1.6 per cent. In absolute numbers, foreign investors own Rs 700 billion or approximately $11 billion of Indian government bonds. At present, the quantitative restriction on foreign investment in government bonds stands at $30 billion. The small scale of foreign ownership implies a substantial upside potential. The internal debt of the government stands at Rs 48.7 trillion. Government securities account for 90 per cent of this amount. Even if the ownership of foreign investors went up by ten times overnight, to $110 billion, it would only amount to 16 per cent of the existing stock of bonds.

A comparison with other emerging economies shows that India greatly lags behind in the proportion of government bonds owned by foreigners. This raises questions on the structure of capital controls in the rupee denominated bond market.

The Working Group on Foreign Investment, chaired by U.K. Sinha, pointed out that the existing regulations create incentives for Indian firms to favour foreign currency borrowings over issuing debt denominated in rupees. It recommended easing the restrictions on rupee denominated debt as a safer way to manage globalisation. The Committee on Financial Sector Reforms, chaired by Raghuram Rajan, also recommended the steady opening up of rupee denominated government and corporate bond markets to foreign investors.

The Sebi study recommends that the existing framework of quantitative restrictions be dismantled. This will encourage greater engagement of foreigners in the government debt market. Since this is rupee denominated, the concerns associated with "original sin" and liability dollarisation do not arise.

If restrictions have to be imposed, the existing quantitative ones could be replaced by percentage limits on foreign ownership. This will enable greater foreign participation as the size of the government bond market increases. Foreign ownership should be capped at a certain percentage of the outstanding government debt, such as at 10 or 15 per cent. The government debt market should be made operationally similar to the equity market. The regulator should allow unrestricted investment till the prescribed limit is reached.

Under this framework, there should not be any distinction between asset classes within the prescribed umbrella limit. In addition, the framework should not create artificial distinctions between investor classes such as foreign institutional investors, qualified foreign investors, sovereign wealth funds, etc. The recent increase in the foreign investment limit in government securities to $30 billion is only applicable to specified classes of foreign investors. These restrictions should be removed. In addition, foreigners should be allowed to participate in onshore currency futures markets so that they can hedge their currency exposure.

A focus for the RBI

Indian Express, 24th September 2013

It needs a well-defined objective and policy instrument.

In his maiden monetary policy announcement, RBI Governor Raghuram Rajan unveiled a mix of easing and tightening measures. He raised the repo rate and lowered the bank rate. In July, the RBI had suddenly raised rates to defend the rupee. Since then, the bank rate, or the MSF rate, has become the operational policy rate, the rate at which commercial banks borrow from the RBI. It is too high for the economy today and needs to be reduced even further.

The decision to cut the MSF rate was obvious. That was the easy part. Rajan also raised the repo rate, which used to be the policy rate before the RBI's actions to defend the rupee in July. This was supposed to indicate the RBI's intent to target inflation by lowering inflationary expectations. Bringing such expectations down is a difficult task for any central bank. For the RBI, the problem is even more difficult since it must balance multiple objectives, has numerous instruments and is not independent.

Rajan will have to work hard to build the RBI's credibility as an inflation targeter. He will need to get rid of its multiple objectives and many instruments. He will have to focus on defining the objective of monetary policy and its instrument clearly, building credibility, being consistent and communicating his policy stance to the public. The success of his term will be measured by how well he is able to anchor inflationary expectations and bring down consumer price inflation. The growth slowdown and high food inflation will make inflation forecasting and targeting difficult. So far, the RBI has not managed to communicate clearly because it has too many instruments and unclear objectives.

In the credit policy announcement, Rajan increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points, from 7.25 per cent to 7.5 per cent. This was clearly intended only as a signal, since restrictions on borrowing from this window were not reversed. While banks can borrow 2 per cent of their liabilities at the MSF rate, after the RBI's July actions they can borrow only 0.5 per cent of their liabilities under the LAF. The target corridor for the overnight interest rate has the MSF rate on top, the repo rate in between and the reverse-repo rate at the bottom. The narrower this corridor, the clearer the RBI's policy stance is. Today, this corridor is too wide and the interbank rate has been moving beyond it.

Rajan's first task is to make the repo rate the operational policy rate. This means the RBI must stop using other instruments for easing or tightening monetary policy. Today, policy objectives are achieved through 10 instruments: foreign market intervention, open market operations, the repo rate (which will eventually become the only instrument), the reverse repo, the MSF or the bank rate, the CRR, the daily balance of the CRR, the amount that can be borrowed through the repo window, the amount that banks can borrow through the MSF window and the SLR. The RBI often suggests that interest rates (which are the price of money) are not affected by liquidity (the quantity of money in the market). The two, it believes, are somewhat independent of each other and can be manipulated to move in different directions. The origins of this framework go back to the control raj, where for many goods like steel and cement, it was assumed that the prices and quantities in the market moved independently of one another.

The RBI will need to clarify its measure of and numerical target for inflation to anchor expectations. In its most recent policy announcement, the target inflation measure was still unclear. In his press statement, Rajan said a WPI inflation of 5 per cent would be achieved by the operating framework put in place by the Urjit Patel committee. However, in his speech he had said he would focus on CPI inflation. Consequently, confusion about the RBI's measure of inflation remains. Ideally, the objective inflation measure should be in the monetary policy law, or stated by the government, as it is in other countries. The RBI should be made accountable to achieve that target. It is not the job of the central bank to define its own targets. This reduces accountability. It is likely that a change in the law will happen during Rajan's tenure, but maybe not soon enough.

Short-term pressures on the rupee may deflect the focus from a clean and transparent monetary policy framework for inflation targeting, as we saw in recent weeks. One option is to move to a fully floating exchange rate, while undertaking financial sector reforms to increase the capability of the private sector to hedge its exposure. This would give the RBI monetary policy autonomy, even though the capital account, de-facto, remains open. The other option is to interfere in markets, impose capital controls and mount interest rate defences in response to exchange rate movements. The extent to which Rajan will follow this path remains to be seen. This is not the appropriate direction for India to be moving in and he will undoubtedly be mindful of that.

Today, too much depends on the personalities in power. The way ahead is institutional change. The Indian Financial Code, recommended by the Financial Sector Legislative Reforms Commission, will require the government to give the RBI a clear target, to achieve which it will be given independence and made accountable. The enactment of the code will pave the way to making the RBI an inflation-targeting central bank with a well defined objective and policy instrument. Until then, Rajan will likely walk a tightrope and we may see knee-jerk reactions from the RBI, in its trying to achieve too many objectives with too many instruments. The outcome will also depend on the political pressure on the RBI. The next finance minister may not respect Rajan's decisions. Institutionalising the new framework should be his top priority.